TAX CUT PRESSURE AS NEW BUDGET LOOMS

C O N F I D E N T I A L SECTION 01 OF 02 HONG KONG 000687

SIPDIS

SIPDIS

STATE FOR EAP/CM AND EB
MANILA PASS AMBASSADOR PAUL SPELTZ
TREASURY FOR DAS DLOEVINGER, OASIA-GKOPEKE
USDOC FOR 4420

E.O. 12958: DECL: 02/17/2031
TAGS: PGOV ECON EFIN HK CH
SUBJECT: TAX CUT PRESSURE AS NEW BUDGET LOOMS


Classified By: EP Section Chief Simon Schuchat; Reasons: 1.4 (b/d)


SUMMARY AND COMMENT
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1. (C) With the next Chief Executive election planned for the
first half of 2007, concerns about public acceptance of
government revenue and spending policy are playing a
heightened role in advance of the unveiling of the 2006-07
budget, which will take place on February 22. Hong Kong's
economic performance is expected to be above trend for the
third year in a row, and the small budget surplus that
emerged last year looks set to be repeated. Consequently,
calls are growing among Hong Kong's population for a tax cut.
However, Hong Kong's reliance on accumulated surpluses to
underpin its currency coupled with a volatile revenue base
suggests that any significant revenue cuts offered now might
have to be made up later, and in a more painful fashion,
during what many believe will be an inevitable downturn --
both cyclical and structural -- in the HKG's fiscal
condition. END SUMMARY AND COMMENT

BUDGET COMING NEXT WEEK
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2. (SBU) Financial Secretary Henry Tang's February 22 budget
speech will likely reveal a small revenue surplus for the
second year in a row, thanks to recently strong economic
performance -- 8.2 percent GDP growth in 2004 and an
estimated 7 percent growth for 2005. Amidst higher interest
rates (i.e., higher mortgage payments),it is no surprise
that many in the income tax-paying middle and upper classes
have taken a look at current trends and decided they would
like some money back in the form of a tax cut. There is
widespread speculation that Tang will at minimum deliver a
one-time tax rebate, and that he may go even further than
that.

LONGER TERM STRUCTURAL CHALLENGES...
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3. (SBU) While the budget may look flush at first blush,
there are underlying structural weaknesses that make a tax
cut problematic, given that revenue collections are highly
dependent on the economic cycle. The tax base remains narrow
here. Income taxes and various fees account for most
government revenue, and yields from these sources move up and
down with economic performance and property value swings.
Further, around 20 percent of fiscal intake comes from highly
volatile non-tax sources such as land sales and interest
rate-sensitive returns on accumulated surpluses.


4. (C) This unstable revenue environment funds a government
that must meet the needs of a society with one of the world's
lowest fertility rates, and the aging of the population
promises increased health care and social welfare costs over
time. Consequently, behind the headlines and editorials
calling for tax cuts, there is a quieter agreement among
government officials and analysts that Hong Kong will in the
longer run need to stabilize its revenue base with a
consumption tax (now under consideration) and perhaps fund
increasing health care costs with new contributions.

... CANNOT BE IGNORED
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5. (SBU) Surpluses were the norm in Hong Kong until the Asian
Financial Crisis, global high-tech downturn, and SARS put
government finances under severe pressure after 1997, peaking
with a deficit of 6 percent of GDP in the 2001-02 budget.
Chronic deficits are a special concern here because an
erosion of accumulated fiscal reserves would threaten
confidence in the peg of the Hong Kong dollar to the U.S.
dollar, which is backed by those surpluses. The necessity of
bringing the budget back into balance forced Hong Kong to dig
out of its recent deficits in part by reining in expenses,
including making painful cuts over the years to civil service
employment and compensation.

A DIFFICULT CHOICE
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6. (C) Taking all this together, there is a strong case to be
made that tampering with cyclical surpluses is a tradeoff
between collecting revenue now, when times are good, or

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making it up at a more painful juncture in the future, when a
downward cycle might well raise the prospect of chronic
deficits, forcing a tax hike at an economically painful and
politically inopportune time. Given that the HKG is already
expected to be forced to strengthen its finances by
introducing a consumption tax, any compounding of that
sensitive move with a further tax hike or painful expenditure
cuts would create significant political tension down the
road.

IMF WEIGHS IN
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7. (C) The IMF cautioned against cutting taxes this week, and
a contact there told us that he hoped coverage of a report
released by his organization would help Tang avoid giving in
to public pressure. Citigroup Analyst Joe Lo shared with us
his research note titled "Candy First, Bitter Pills Later,"
where he concluded that the HKG probably has some time amidst
the strong economic cycle to make small tax cuts and modestly
increase expenditures -- but painful fiscal reforms to
address public health care and social welfare issues are
inevitable.
Cunningham